Feb. 15 (Bloomberg) -- Investors who made some of the
biggest profits from the 2007 bust in U.S. mortgages are once
again in agreement. This time, they’re going long.

Hedge fund manager Kyle Bass, who made $500 million betting
against subprime debt in the crash, is raising a fund to buy
home loan securities. He’s joining Greg Lippmann, a former
Deutsche Bank AG trader, and John Paulson, who made $15 billion
in 2007, in betting on default prone mortgages. Goldman Sachs
Group Inc. and American International Group Inc. have also
emerged as buyers this year as trading more than doubled for
non-agency mortgage notes.

The $1.1 trillion market for U.S. mortgage bonds without
government-backing is joining a global rally in everything from
stocks and commodities to company loans, as confidence grows
that Europe’s sovereign debt crisis will be contained. Investors
are speculating the riskiest mortgage securities are priced to
withstand an economic slowdown and home price declines even as
President Barack Obama and the Federal Reserve pursue policies
to combat the six-year residential real-estate slump.

“You can end up, even using severe assumptions on things
such as home prices and defaults, with a very high yield based
on the prices that bonds are trading at,” Larry Penn, chief
executive officer of Old Greenwich, Connecticut-based Ellington
Financial LLC, said yesterday in a telephone interview.
“Especially with interest rates this low, if you can buy
something where you can end up with a double-digit yield under
severe assumptions, that’s great.”

Toxic Debt

Typical prices for the most-senior bonds tied to option
adjustable-rate mortgages rose to 55 cents on the dollar last
week from 49 cents in November, according to Barclays Capital.

Option ARMs, a type of loan that allowed borrowers to pay
less than the monthly interest due with the shortfall added to
the balance, were among the “toxic” debt that the Financial
Crisis Inquiry Commission said was at the center of the
“corrosion of mortgage-lending standards” that helped fuel the
housing boom and subsequent bust. About 45 percent of the option
ARM loans that are in bonds are delinquent, according to
JPMorgan Chase & Co. data.

The rally may help bolster fixed-income trading revenue
that fell at the five biggest U.S-based Wall Street banks by
more than 20 percent last year, excluding accounting gains,
according to data compiled by Bloomberg.

AIG Rescue

The debt has previously gained since markets seized up in
2008. Prices rose to 65 cents in February 2011 from a low of 33
cents in 2009. That reversed when the Federal Reserve Bank of
New York in April began auctioning off bonds it acquired in the
2008 government rescue of insurer AIG, sparking a rout in credit
markets that intensified as investor concern grew that Europe’s
sovereign debt crisis would infect bank balance sheets globally.

The New York Fed has taken advantage of the recent rally to
try again. This time, the Fed switched tactics. After inviting
more than 40 broker-dealers to take part in a series of
auctions, it asked only a handful of banks to bid on the debt.

Goldman Sachs last week bought $6.2 billion of mortgage
bonds from the AIG rescue. It held onto much of that to
distribute later to clients at higher prices, regulatory data on
trading volumes show.

“That’s a pretty strong message that Goldman is sending
about not being in a hunkered down mode,” said Steven Delaney,
an analyst at San Francisco-based JMP Securities LLC who covers
real estate investment trusts that invest in mortgages.

Benmosche Increased Investments

The offering followed a Jan. 19 sale by the central bank to
Credit Suisse Group AG, which said it immediately resold a
“significant” portion of $7 billion of bonds. AIG bought some
of the securities from the Zurich-based bank, said people with
knowledge of the transactions, who declined to be identified as
the buying is private.

AIG’s holdings of residential mortgage-backed securities
surged 64 percent to $32.6 billion in the first nine months of
2011, according to regulatory filings. Chief Executive Officer
Robert Benmosche has increased the holdings as he seeks to boost
annual pre-tax investment income by as much as $700 million.

The insurer has participated in the Fed auctions and found
other sources of the securities, such as banking institutions
looking to reduce risk-weighted assets, Benmosche said today at
a conference in New York sponsored by Bank of America Corp. The
Fed last year rejected AIG’s bid for the entire pool, called
Maiden Lane II, before beginning to auction off the assets.

“We got some really good high quality mortgages, higher
quality, I should say, than Maiden Lane II,” Benmosche said.
“A lot of people think the lion’s share of Maiden Lane II is
still owned by AIG after the auctions. That is not the case.”

Mark Herr, a spokesman for New York-based AIG, declined to
comment on this year’s purchases.

Ellington Buys

Ellington Financial LLC, which is run by hedge-fund manager
Michael Vranos’ Ellington Financial Management LLC, said it
bought bonds sold in each of the two Fed auctions.

Trading in non-agency mortgage bonds averaged $15.6 billion
per week in the first six periods of this year, compared with
$6.6 billion in the final 20 weeks of 2011, according to data
reported to regulators and compiled by Empirasign Strategies
LLC, a New York-based provider of information on securitization
trading.

The securities are bouncing back “almost like a coiled
spring,” Clayton DeGiacinto, chief investment officer of hedge
fund Axonic Capital LLC said in a telephone interview.

“Risk appetite among the dealers” has increased, said
DeGiacinto, a former Goldman Sachs trader whose New York-based
firm oversees about $350 million. “A lot of people came in on
Wall Street in January and realized they didn’t have any
inventory.”

Dealer Inventories

Dealers have trimmed their stockpiles of debt including
corporate bonds and mortgage securities without government
backing to the lowest level in almost a decade, Fed data show.
The holdings fell to $43 billion as of the week ended Feb. 1,
down from 2011’s peak in May of $94.9 billion.

The Fed’s portfolio from AIG includes bonds backed by the
types of home loans with some of the highest default rates, such
as subprime, Alt-A and option ARMs. Those securities, which can
be difficult to value, offer a chance for a bigger profit to a
savvy investor.

Renewed demand doesn’t mean a property rebound is near.
Appetite for the non-agency debt is growing because of the
potentially high yields rather than any changes in bond buyers’
views on housing, said DeGiacinto.

Almost 28.3 percent of home loans pooled in bonds without
government backing are at least 60 days delinquent, in
foreclosure or already turned into seized property, according to
data compiled by Bloomberg. The share has fallen from a record
30.2 percent in March 2010 as new defaults eased while
regulatory probes into foreclosure practices slowed liquidations
of bad debt.

Bass Generally Bearish

Bass is seeking to raise money for a residential mortgage-backed securities fund, according to two people with knowledge
of the plans, who asked not to be identified because the
information is private.

“We believe that regulatory changes, rating downgrades and
continued bank deleveraging have caused a dislocation between
credit fundamentals and prices for many asset-backed
securities,” his firm, Hayman Capital Management LP, said in
marketing documents.

Bass has remained generally bearish amid mounting concern
driven by government deficits. He told overseers of Texas’s
state university endowment on Feb. 2 that “as every day goes
by, I see deflation in the things you own and inflation in the
things you need.”

Chris Kirkpatrick, general counsel at Dallas-based Hayman,
declined to comment.

‘The Big Short’

Paulson became a billionaire in 2007 by betting against
subprime mortgages, a trade that was documented in Michael
Lewis’s “The Big Short.” He started buying residential and
commercial mortgage securities in late 2008 and 2009. Paulson &
Co.’s Credit Opportunities Ltd. fund gained 3.5 percent last
month after losing 18 percent in 2011, according to an investor
letter.

Lippmann, also featured in Lewis’s 2010 book after betting
against mortgages while at Deutsche Bank, says residential
mortgage-backed securities are priced the best for a souring
economy compared with other investments. He made $1.5 billion in
2007 and 2008 for the Frankfurt-based lender, according to a
U.S. Senate report.

“The product is as cheap to broader markets as it has been
in a long time,” Lippmann wrote in a Feb. 10 letter to clients
of his hedge fund LibreMax Capital LLC. “Perhaps more
importantly, we believe RMBS has potentially less downside to
adverse economic scenarios.”

Global Risks

LibreMax, which he co-founded after leaving Deutsche Bank
in 2010, has been reducing the hedges used to balance the risks
of the residential debt that accounts for about two-thirds of
his holdings, he said.

While Lippmann wrote he was “heartened by the recent
string of largely positive U.S. economic data,” he’s “wary of
a second-half slowdown amid continuing global risks.” His New
York-based firm, which oversees $1.1 billion, is forecasting a 6
percent decline in home prices from January through April 2013.

Bonds backed by so-called Alt-A mortgages, which fall
between prime and subprime in terms of projected defaults, offer
yields of more than 7 percent “to stressed scenarios,”
according to JPMorgan analysts led by John Sim.

Losses on the underlying loans total 10.3 percent of the
original balances so far, with 30 percent of remaining borrowers
delinquent, the bank’s data show. In a “severely negative”
outcome, where home prices decline 10.7 percent, 55.3 percent of
the existing borrowers will default, leaving investors with
cumulative losses of 21.8 percent, the analysts forecast.

CQS, Cerberus Raising Funds

The S&P/Case-Shiller index of property values in 20 cities
declined 3.7 percent in November from a year earlier, compared
with the 3.3 percent drop projected by economists. Values are
down almost 33 percent from a July 2006 peak.

Other firms that have started funds include CQS U.K. LLP,
the $11.2 billion money-management firm run by Michael Hintze in
London. Its CQS ABS Alpha Fund, run by Alistair Lumsden, started
this month with $140 million, according to a Feb. 2 letter sent
to clients. Cerberus Capital Management LP raised $800 million
for an RMBS Opportunities Fund, according to a person familiar
with the matter.

‘Lottery Ticket’

Recent gains mean residential debt no longer offers
“double-digit” returns, Bill Roth, co-chief investment officer
of Two Harbors Investment Corp., said on a Feb. 8 conference
call with analysts. Two Harbors is a publicly traded REIT run by
hedge-fund firm Pine River Capital Management LP; both have said
they’ve been buying subprime debt

“Still, if you compare it to almost anything else that’s
available -- in an interest rate environment where the 10-year
Treasury is below 2 percent, and most other fixed income assets
yield 6 percent or less -- yields of 7 percent, 8 percent, 9
percent are still appealing,” Roth said.

That’s not even taking into account the “free lottery
ticket” given by President Barack Obama’s legislation that
would enable refinancing of borrowers into government-backed
loans, which has been given small odds of passing Congress, said
Tom Siering, CEO at Two Harbors and a partner at Pine River.

The bounce in prices may not directly help lenders. While
the five biggest U.S. banks held about $115 billion in mortgage
securities without government-backing as of Sept. 30, the most-recent regulatory data available, changes in their values mostly
don’t turn up in the lenders’ earnings because of their
accounting policies.

Higher prices do mean it’s more likely that U.S. banks can
sell off bonds if they want to restructure their portfolios,
said Marty Mosby, an analyst at Guggenheim Securities LLC in
Memphis, Tennessee.

Strong Reception

Barclays Capital analysts led by Ajay Rajadhyaksha said in
a Feb. 10 report the strong reception to the Fed’s sales may
also “entice” European banks into attempting to offload debt,
a move that could set the market back.

U.S. banks hold $780 billion of delinquent first mortgages,
with $124 billion of that amount representing borrowing above
the value of the homes serving as collateral, according to data
from the JPMorgan analysts.

Banks’ mortgage losses are “going to improve relative to
what they were last year and remain elevated compared to
historic norms” at least through 2013 because of borrowers’
negative equity and loan modifications, Mosby said. That means
charge-offs of about 1 percent, about double the typical rate.

For all the gains in the market, issuance may not be any
closer to reviving. Less than $1.5 billion of new U.S. mortgages
have been packaged into securities without government backing
since mid-2008, compared with the record of about $1.2 trillion
in each of 2005 and 2006.

That’s part of the downside of all the cheap bonds. Buying
and securitizing new loans just doesn’t look attractive yet in
comparison, according to Siering.